One of the best lessons I’ve learned over my career as an investment analyst is the myth of excellent management or “great execution” is really just that – a myth.
When I see companies in troubled industries reporting quarter after quarter of great results, while all of their peers are getting killed, I know a fraud is going on. I remember in the early 2000s, WorldCom kept reporting profits when all of the other long-distance carriers were getting killed. I knew it couldn’t last. And it didn’t. WorldCom’s accounting was revealed to be a fraud – the company was counting its network access costs as capital expenses. Once the real numbers came out, the company collapsed in what was the largest bankruptcy in American history at that point.
About three years ago, I saw Goldman Sachs reporting quarter after quarter of unbelievable results when all of the other investment banks were hurting. I spent a lot of time looking at its numbers – which didn’t make any sense. It reminded me of Enron. It kept reporting bigger and bigger profits, but lost more money every year in cash. And its debt balances kept growing.
I wrote a lot about it in my daily e-letter “The S&A Digest,” but I never officially recommended shorting Goldman in my newsletter because I literally couldn’t figure out how Goldman Sachs was doing it. I couldn’t find the smoking gun … but I knew a giant fraud would be discovered there, eventually.
In October 2008, I figured out part of the big secret: Goldman had insured all of its subprime exposure via AIG. This allowed it to book huge profits on its subprime investments long before they were actually paid off because the bonds were insured. Of course, it was all a sham – AIG didn’t have nearly enough money to pay off any of the insurance. (See the October issue of my “Investment Advisory” for more details.) A source close to the company even told me how big the exposure to AIG really was – $20 billion. That’s roughly 100 percent of the profit Goldman claimed in 2006 and 2007, at the height of the credit bubble. Goldman completely denied my report and claimed it had zero exposure to AIG.
As was subsequently revealed in the spring of 2009, my report was right on the money. Goldman had roughly $20 billion in exposure to AIG and received roughly $14 billion of money the federal government used to bail out AIG.
But I completely missed one big part of the story. And once this fact becomes common knowledge, it will probably mean jail time for several leading Goldman executives and the end of the firm. What did I miss? The entire Goldman-AIG relationship was a complete sham. Let me explain.
Goldman eventually admitted it had insured roughly $20 billion worth of subprime collateralized debt obligations with AIG and had major exposure to the firm. But the New York Federal Reserve and Goldman Sachs never revealed this critical fact: Goldman didn’t merely buy insurance on a bunch of random subprime CDOs. It actually bought insurance on special CDOs it had put together and sold to its own clients. In other words, Goldman knew more about these CDOs than anyone else. Goldman bought insurance on these CDOs because it knew they’d collapse.
This is tantamount to building a house, planting a bomb in it, selling it to an unsuspecting buyer, and buying $20 billion worth of life insurance on the homeowner – who you know is going to die!
These facts all came to light because of research done by the office of Darrell Issa, the ranking Republican on the House Committee on Oversight and Government Reform. These new documents will certainly lead to a full investigation of the Goldman-AIG dealings and the subsequent $180 billion bailout led by the New York Federal Reserve.
My bet? Heads will roll. If you own Goldman Sachs, you’d better sell.